State financial crisis? What crisis?

Lenders love Illinois

Imagine living in a state with such rosy financial prospects that it can borrow money at interest rates less than 1 percent higher than the rate for U.S. Treasury notes, considered the gold standard of safety in American financial markets.

Illinois is such a state. Just check the bond markets.

When the state borrowed $300 million in May to pay for infrastructure such as roads and schools, 11 banks bid for the bonds, which are backed by sales tax revenue. Standard & Poor’s rated the bonds at AAA, the highest possible grade.

“The ratings reflect what we view as a diverse economic base and above-average income levels supporting sales tax collections, and extremely strong debt service coverage,” gushed S&P analyst Robin Prunty in a written statement.

The projected revenue stream to repay the debt was more than 20 times the principal, and Wall Street went bananas. When the dust settled, Wells Fargo ended up buying the bonds and reselling them to investors who are getting an average interest rate of slightly less than 3.3 percent, and they must pay taxes on the income.

Just one month later, the same analysts who pegged Illinois debt as a can’t-miss proposition issued ominous warnings about a $1.3 billion bond issue. To be sure, the bonds were fundamentally different than the bonds sold one month earlier. For one thing, the bonds sold in June were tax exempt. More importantly, at least in the eyes of Wall Street, the latter bonds were backed, not with a statutorily guaranteed cut of sales tax revenue, but by the “full faith and credit” of Illinois government, which, apparently, isn’t worth much.

Citing Illinois’ large pension obligations, Standard & Poor’s gave the bonds an A3 rating, the lowest grade given to any state in the nation, which guaranteed a high interest rate – the average rate was slightly more than 5 percent, and with no taxes due on income. Once again, Wall Street went bananas, with more than $9 billion in orders for the $1.3 billion in bonds. The frenzy drove down the price of government-issued bonds on the overall market that day by one-tenth of 1 percent, said John Sinsheimer, the state’s director of capital markets.

While the state’s poor credit rating and resulting high interest rates for the bonds is expected to add $130 million to the cost of borrowing the money over the next 25 years, it could have been worse. The state had braced itself for an even higher interest rate, according to assistant state budget director Abdon Pallasch, but the appetite for the debt softened the hit.

“When you sell your house, you always like to have seven bids,” Sinsheimer said.

Noting that Illinois has not defaulted on a bond since the 1840s, Pallasch and Sinsheimer said Illinois bonds are safe investments. Marc Joffe, a San Francisco consultant, agrees.

“I think people have vastly inflated estimates of how risky Illinois bonds are,” says Joffe, who once worked for Moody’s Investors Service, which shares Standard & Poor’s pessimistic views on Illinois’ bonds. “There’s not a lot of distance between Illinois and junk (bond status).”

If he were doing the math – and he has – Joffe said that he would rate Illinois at between AA and AAA, which is the highest possible grade. In a paper published last month, Joffe compared Illinois with Indiana, which has a high credit rating from Wall Street, and found that while bonds issued in the Land of Lincoln are riskier than bonds issued by the Hoosier State, the risk in both cases is negligible. He likens the difference to the odds of dying in a plane crash versus the odds of dying in an automobile accident. Traveling in a a car is riskier, he says, but the odds are so remote that virtually no one takes them into account when deciding how to get from Point A to Point B.

The central question, Joffe said in an interview, is what is the probability that a bond issuer will default and how much are investors likely to recover if that happens. In that context, states have far better records than the private sector.

No state has defaulted since 1933, when Arkansas didn’t pay bondholders, and in that case, the federal government stepped in and made investors whole.

“There’s been no situation where a state defaulted after 1900 and bondholders lost money,” Joffe said. “It’s very exciting to say that Illinois is about to go bankrupt. You don’t want to hear that man wasn’t bitten by a dog.”

In his paper, Joffe doesn’t defend Illinois’ fiscal decisions, but he says the sky is far from falling.

“Despite its poor fiscal policies, Illinois has not yet accumulated a dangerous level of debt relative to the size of its economy,” Joffe writes. “Nor has it taken on pension burdens that exceed the state’s ability to raise revenue. … It is reasonable to expect that Illinois will continue to be home to a large number of high-income taxpayers and profitable companies.”